Links for March 25

Some links, on short-termism, trade, the Fed and other things.

Senators Tammy Baldwin and Jeff Merkley have introduced a bill to limit activist investors’ ability to push for higher payouts. The bill, which is cosponsored by Bernie Sanders and Elizabeth Warren, would strengthen the 13D disclosure requirements for hedge funds and others acquiring large positions in a corporation. This is obviously just one piece of a larger agenda, but it’s good to see the “short-termism’ conversation leading to concrete proposals.

I’m pleased to be listed as one of the supporters of the bill, but I think the strongest endorsement is this furious reaction from a couple of hedge fund dudes. It’s funny how they take it for granted that shareholder democracy is on the same plane as democracy democracy, but my favorite bit is, “Shareholders do not cause bad management, just as voters do not cause bad politicians.” This sounds to me like an admission that shareholders are functionless parasites — if they aren’t responsible for the quality of management, what are we paying them all those dividends for?

I wrote a twitter essay on why the US shouldn’t seek a more favorable trade balance.

Jordan Weissman thinks I was “a bit ungenerous” to Trump.

My Roosevelt Institute colleague Carola Blinder testified recently on reform of the Fed, making the critical point that we need to take monetary policy seriously as a political question. “Contrary to conventional thinking, the rules of central banking are not neutral: Both monetary policy and financial supervision have profound effects on income and wealth inequality … [and] are the product of political contestation and compromise.” Relatedly, Mark Thoma suggests that the Fed “cares more about the interests of the rich and powerful than it does the working class”; his solution, as far as I can tell, is to hope that it doesn’t.

Matt Bruenig has a useful post on employment by age group in the US v the Nordic countries. As he shows, the fraction of people 25-60 working there is much higher than the fraction here (though workers here put in more hours). This has obvious relevance for the arguments of the No We Can’t caucus that there’s no room for more stimulus, because demographics.

Screen Shot 2016-03-25 at 10.14.36 AM

A reminder: “Ricardian equivalence” (debt and tax finance of government spending have identical effects on private behavior) was explicitly denied by David Ricardo, and the “Fisher effect” (persistent changes in inflation lead to equal movements of nominal interest rates, leaving real rates unchanged) was explicitly denied by Irving Fisher. One nice thing about this piece is it looks at how textbooks describe the relationship between the idea and its namesake. Interesting, Mankiw gets Fisher right, while Delong and Olney get him wrong: They falsely attribute to him the orthodox view that nominal interest rates track inflation one for one, when in fact he argued that even persistent changes in inflation are mostly not passed on to nominal rates.

Here is a fascinating review of some recent books on the Cold War conflicts in Angola. One thing the review brings out was how critical the support of Cuba was to South Africa’s defeat there, and how critical that defeat in turn was to the end of apartheid. We tend to take it for granted that history had to turn out as it did, but it’s worth asking if, in the absence of Castro’s commitment to Angola, white rule in South Africa might have ended much later, or not at all.

 

At Jacobin: The Fed Doesn’t Work for You

I have a new piece up at Jacobin on December’s rate hike. In my experience, the editing at Jacobin is excellent. But for better or worse, they don’t go for footnotes. So I’m reposting this here with the original notes. And also for comments, which Jacobin (perhaps wisely) doesn’t allow.

I conveyed some of the same views on “What’d You Miss?” on Bloomberg TV a couple weeks ago. (I come on around 13:30.)

 

To the surprise of no one, the Federal Reserve recently raised the federal funds rate — the interest rate under its direct control — from 0–0.25 percent to 0.25–0.5 percent, ending seven years of a federal funds rate of zero.

But while widely anticipated, the decision still clashes with the Fed’s supposed mandate to maintain full employment and price stability. Inflation remains well shy of the Fed’s 2 percent benchmark (its interpretation of its legal mandate to promote “price stability”) — 1.4 percent in 2015, according to the Fed’s preferred personal consumption expenditure measure, and a mere 0.4 percent using the consumer price index — and shows no sign of rising.

US GDP remains roughly 10 percent below the pre-2008 trend, so it’s hard to argue that the economy is approaching any kind of supply constraints. Set aside the fundamental incoherence of the notion of “price stability” (let alone of a single metric to measure it) — according to the Fed’s professed rulebook, the case for a rate increase is no stronger today than a year or two ago. Even the business press, for the most part, fails to see the logic for raising rates now.

Yet from another perspective, the decision to raise the federal funds rate makes perfect sense. The consensus view considers the main job of central banks to be maintaining price stability by adjusting the short-term interest rate. (Lower interest rates are supposed to raise private spending when inflation falls short of the central bank’s target, and higher interest rates are supposed to restrain spending when inflation rises above the target.) But this has never been the whole story.

More importantly, the central bank helps paper over the gap between ideals and reality — the distance between the ideological vision of the economy as a system of market exchanges of real goods, and the concrete reality of production in pursuit of money profits.

Central banks are thus, in contemporary societies, one of the main sites at which capitalism’s “Polanyi problem” is managed: a society that truly subjected itself to the logic of market exchange would tear itself to pieces. But the conscious planning that confines market outcomes within tolerable bounds has to be hidden from view because if the role of planning was acknowledged, it would undermine the idea of markets as natural and spontaneous and demonstrate the possibility of conscious planning toward other ends.

The Fed is a central planner that dare not speak its name. [1]

One particular problem for central bank planners is managing the pace of growth for the system as a whole. Fast growth doesn’t just lead to rising prices — left to their own devices, individual capitalists are liable to bid up the price of labor and drain the reserve army of the unemployed during boom times. [2] Making concessions to workers when demand is strong is rational for individual business owners, but undermines their position as a class.

Solving this coordination problem is one of modern central bankers’ central duties. They pay close attention to what is somewhat misleadingly called the labor market, and use low unemployment as a signal to raise interest rates.

So in this respect it isn’t surprising to see the Fed raising rates, given that unemployment rates have now fallen below 5 percent for the first time since the financial crisis.

Indeed, inflation targeting has always been coupled with a strong commitment to restraining the claims of workers. Paul Volcker is now widely admired as the hero who slew the inflation dragon, but as Fed chair in the 1980s, he considered rolling back the power of organized labor — in terms of both working conditions and wages — to be his number one problem. [3] Volcker described Reagan’s breaking of the air-traffic controllers union as “the single most important action of the administration in helping the anti-inflation fight.”

As one of Volcker’s colleagues argued, the fundamental goal of high rates was that

labor begins to get the point that if they get too much in wages they won’t have a business to work for. I think that really is beginning to happen now and that’s why I’m more optimistic. . . . When Pan Am workers are willing to take 10 percent wage cuts because the airlines are in trouble, I think those are signs that we’re at the point where something can really start to happen.

Volcker’s successors at the Fed approached the inflation problem similarly. Alan Greenspan saw the fight against rising prices as, at its essence, a project of promoting weakness and insecurity among workers; he famously claimed that “traumatized workers” were the reason strong growth with low inflation was possible in the 1990s, unlike in previous decades.

Testifying before Congress in 1997, Greenspan attributed the “extraordinary’” and “exceptional” performance of the nineties economy to “a heightened sense of job insecurity” among workers “and, as a consequence, subdued wages.”

As Greenspan’s colleague at the Fed in the 1990s, Janet Yellen took the same view. In a 1996 Federal Open Market Committee meeting, she said her biggest worry was that “firms eventually will be forced to bid up wages to retain workers.” But, she continued, she was not too concerned at the moment because

while the labor market is tight, job insecurity also seems alive and well. Real wage aspirations appear modest, and the bargaining power of workers is surprisingly low . . . senior workers and particularly those who have earned wage premia in the past, whether it is due to the power of their unions or the generous compensation policies of their employers, seem to be struggling to defend their jobs . . . auto workers are focused on securing their own benefits during their lifetimes but appear reconciled to accepting two-tier wage structures . . .

And when a few high-profile union victories, like the Teamsters’ successful 1997 strike at UPS, seemed to indicate organized labor might be reviving, Greenspan made no effort to hide his displeasure:

I suspect we will find that the [UPS] strike has done a good deal of damage in the past couple of weeks. The settlement may go a long way toward undermining the wage flexibility that we started to get in labor markets with the air traffic controllers’ strike back in the early 1980s. Even before this strike, it appeared that the secular decline in real wages was over.

The Fed’s commitment to keeping unemployment high enough to limit wage gains is hardly a secret — it’s right there in the transcripts of FOMC meetings, and familiar to anyone who has read left critics of the Fed like William Greider and Doug Henwood. The bluntness with which Fed officials take sides in the class war is still striking, though.

Of course, Fed officials deny they’re taking sides. They justify policies that keep workers too weak, disorganized, and traumatized to demand higher wages by focusing on the purported dangers of low unemployment. Lower unemployment, they say, leads to higher money wages, and higher money wages are passed on as higher prices, ultimately leaving workers’ real pay unchanged while eroding their savings.

So while it might look like naked class warfare to deliberately raise unemployment to keep wage demands “subdued”, the Fed assures us that it’s really in the best interests of everyone, including workers.

Keeping Wages in Check

The low-unemployment-equals-high-prices story has always been problematic. But for years its naysayers were silenced by the supposed empirical fact of the Phillips curve, which links low unemployment to higher inflation.

The shaky empirical basis of the Phillips curve was the source of major macroeconomic debates in the 1970s, when monetarists claimed that any departure from unemployment’s “natural” rate would lead inflation to rise, or fall, without limit. This “vertical Phillips curve” was used to deny the possibility of any tradeoff between unemployment and inflation — a tradeoff that, in the postwar era, was supposed to be managed by a technocratic state balancing the interests of wage earners against the interest of money owners.

In the monetarist view, there were no conflicting interests to balance, since there was just one possible rate of unemployment compatible with a stable price system (the “Non Accelerating Inflation Rate of Unemployment”). This is still the view one finds in most textbooks today.

In retrospect, the 1970s debates are usually taken as a decisive blow against the “bastard Keynesian” orthodoxy of the 1960s and 1970s. They were also an important factor in the victory of monetarism and rational expectations in the economics profession, and in the defeat of fiscal policy in the policy realm.

But today there’s a different breakdown in the relationship between unemployment and inflation that threatens to dislodge orthodoxy once again. Rather than a vertical curve, we now seem to face a “horizontal” Phillips curve in which changes in unemployment have no consequences for inflation one way or another.

Despite breathless claims about the end of work, there hasn’t been any change in the link between output and employment; and low unemployment is still associated with faster wage growth. But the link between wage growth and inflation has all but disappeared.

Annual wage growth for nonsupervisory workers (X) and CPI inflation (Y), 1965–1995.
Annual wage growth for nonsupervisory workers (X) and CPI inflation (Y), 1965–1995.

 

Annual wage growth for nonsupervisory workers (X) and CPI inflation (Y), 1995–2015.
Annual wage growth for nonsupervisory workers (X) and CPI inflation (Y), 1995–2015.

This gap in the output-unemployment-wages-inflation causal chain creates a significant problem for central bank ideology.

When Volcker eagerly waited for news on the latest Teamsters negotiations, it was ostensibly because of the future implications for inflation. Now, if there is no longer any visible link between wage growth and inflation, then central bankers might stop worrying so much about labor market outcomes. Put differently, if the Fed’s goal was truly price stability, then the degree to which workers are traumatized would no longer matter so much.

But that’s not the only possibility. Central bankers might want to maintain their focus on unemployment and wages as immediate targets of policy for other reasons. In that case they’d need to change their story.

The current tightening suggests that this is exactly what’s happening. Targeting “wage inflation” seems to be becoming a policy goal in itself, regardless of whether it spurs price increases.

recent piece by Justin Wolfers in the New York Times is a nice example of where conventional wisdom is heading: “It is only when nominal wage growth exceeds the sum of inflation (about 2 percent) and productivity growth (about 1.5 percent) that the Fed needs to be concerned. . .”

This sounds like technical jargon, but if taken seriously it suggests a fundamental shift in the objectives of monetary policy.

By definition, the change in the wage share of output is equal to the rise in money wages minus the sum of the inflation rate and the increase in labor productivity. To say “nominal wage growth is greater than the sum of inflation and productivity growth” is just a roundabout way of saying “the wage share is rising.” So in plain English, Wolfers is saying that the Fed should raise rates if and only if the share of GDP going to workers threatens to increase.

Think for a moment about this logic. In the textbook story, wage growth is a problem insofar as it’s associated with rising inflation. But in the new version, wage growth is more likely to be a problem when inflation stays low.

Wolfers is the farthest thing from a conservative ideologue. His declaration that the Fed needs to guard against a rise in the wage share is simply an expression of conventional elite wisdom that comes straight from the Fed. A recent post by several economists at the New York Fed uses an identical definition of “overheating” as wage growth in excess of productivity growth plus inflation.

Focusing on wage growth itself, rather than the unemployment-inflation nexus, represents a subtle but far-reaching shift in the aim of policy. According to official rhetoric, an inflation-targeting central bank should only be interested in the part of wage changes that co-varies with inflation. Otherwise changes in the wage share presumably reflect social or technological factors rather than demand conditions that are not the responsibility of the central bank.

To be fair, linking demand conditions to changes in the distribution between profits and wages, rather than to inflation, is a more realistic than the old orthodoxy that greater bargaining power for workers cannot increase their share of the product. [4]

But it sits awkwardly with the central bank story that higher unemployment is necessary to keep down prices. And it undermines the broader commitment in orthodox economics to a sharp distinction — both theoretically and policy-wise — between a monetary, demand-determined short run and a technology and “real”-resources-determined long run, with distributional questions firmly located in the latter.

There’s a funny disconnect in these conversations. A rising wage share supposedly indicates an overheating economy — a macroeconomic problem that requires a central bank response. But a falling wage share is the result of deep structural forces — unrelated to aggregate demand and certainly not something with which the central bank should be concerned. An increasing wage share is viewed by elites as a sign that policy is too loose, but no one ever blames a declining wage share on policy that is too tight. Instead we’re told it’s the result of technological change, Chinese competition, etc.

Logically, central bankers shouldn’t be able to have it both ways. In practice they can and do.

The European Central Bank (ECB) — not surprisingly, given its more overtly political role — has gone further down this road than the Fed. Their standard for macroeconomic balance appears to be shifting from the NAIRU (Non-Accelerating Inflation Rate of Unemployment) to the NAWRU (Non-Accelerating Wage Rate of Unemployment).

If the goal all along has been lower wage growth, then this is not surprising: when the link between wages and inflation weakens, the response is not to find other tools for controlling inflation, but other arguments for controlling wages.

Indeed finding fresh arguments for keeping wages in check may be the real content of much of the “competitiveness” discourse. Replacing price stability with elevating competitiveness as the paramount policy goal creates a convenient justification for pushing down wages even when inflation is already extremely low.

It’s interesting in this context to look back at the ransom note the ECB sent to the Spanish government during the 2011 sovereign debt crisis. (Similar letters were sent to the governments of other crisis-hit countries.) One of the top demands the ECB made as a condition of stabilizing the market for government debt was the abolition of cost-of-living (COLA) clauses in employment contracts — even if adopted voluntarily by private employers.

Needless to say this is far beyond the mandate of a central bank as normally understood. [5] But the most interesting thing is the rationale for ending COLA clauses. The ECB declared that cost-of-living clauses are “a structural obstacle to the adjustment of labour costs” and “contribute to hampering competitiveness.”

This is worth unpacking. For a central bank concerned with price stability, the obvious problem with indexing wages to prices (as COLA clauses do) is that it can lead to inflationary spirals, a situation in which wages and prices rise together and real wages remain the same.

But this kind of textbook concern is not the ECB’s focus; instead, the emphasis on labor costs shows an abiding interest in tamping down real wages. In the old central bank story, wage indexing was supposedly bad because it didn’t affect (i.e., raise) real wages and only led to higher inflation. In the new dispensation, wage indexing is bad precisely because it does affect real wages. The ECB’s language only makes sense if the goal is to allow inflation to erode real wages.

The Republic of the Central Banker

Does the official story matter? Perhaps not.

The period before the 2008 crisis was characterized by a series of fulsome tributes to the wisdom of central banking maestros, whose smug and uncritical tone must be causing some embarrassment in hindsight.

Liberals in particular seemed happy to declare themselves citizens of the republic of the central bankers. Cristina Romer — soon to head President Obama’s Council of Economic Advisers — described the defeat of postwar Keynesian macroeconomics as a “glorious counterrevolution” and explained that

better policy, particularly on the part of the Federal Reserve, is directly responsible for the low inflation and the virtual disappearance of the business cycle . . . The story of stabilization policy of the last quarter century is one of amazing success. We have seen the triumph of sensible ideas and have reaped the rewards in terms of macroeconomic performance. The costly wrong turn in ideas and macropolicy of the 1960s and 1970s has been righted and the future of stabilization looks bright.

The date on which the “disappearance of the business cycle” was announced? September 2007, two months before the start of the deepest recession in fifty years.

Romer’s predecessor on Clinton’s Council of Economic Advisers (and later Fed vice-chair) Alan Blinder was so impressed by the philosopher-kings at the central bank that he proposed extending the same model to a range of decisions currently made by elected legislatures.

We have drawn the line in the wrong place, leaving too many policy decisions in the realm of politics and too few in the realm of technocracy. . . . [T]he argument for the Fed’s independence applies just as forcefully to many other areas of government policy. Many policy decisions require complex technical judgments and have consequences that stretch into the distant future. . . . Yet in such cases, elected politicians make the key decisions. Why should monetary policy be different? . . . The justification for central bank independence is valid. Perhaps the model should be extended . . . The tax system would surely be simpler, fairer, and more efficient if . . . left to an independent technical body like the Federal Reserve rather than to congressional committees.

The misguided consensus a decade ago about central banks’ ability to preserve growth may be just as wrong about central banks’ ability to derail it today. (Or at least, to do so with the conventional tools of monetary policy, as opposed to the more aggressive iatrogenic techniques of the ECB.)

The business press may obsess over every movement of the Fed’s steering wheel, but we should allow ourselves some doubts that the steering wheel is even connected to the wheels.

The last time the Fed tightened was ten years ago; between June 2004 and July 2006, the federal funds rate rose from 1 percent to 5 percent. Yet longer-term interest rates — which matter much more for economic activity — did not rise at all. The Baa corporate bond rate and thirty-year mortgage, for instance, were both lower in late 2006 than they had been before the Fed started tightening.

And among heterodox macroeconomists, there is a strong argumentthat conventional monetary policy no longer plays an important role in the financial markets where longer-term interest rates are set. Which means it has at best limited sway over the level of private spending. And the largest impacts of the rate increase may not be in the US at all, but in the “emerging markets” that may be faced with a reversal of capital flows back toward the United States.

Yet whatever the concrete effects of the Fed’s decision to tighten, it still offers some useful insight into the minds of our rulers.

We sometimes assume that the capitalist class wants growth at any cost, and that the capitalist state acts to promote it. But while individual capitalists are driven by competition to accumulate endlessly, that pressure doesn’t apply to the class as a whole.

A regime of sustained zero growth, by conventional measures, might be difficult to manage. But in the absence of acute threats to social stability or external competition (as from the USSR during the postwar “Golden Age”), slow growth may well be preferable to fast growth, which after all empowers workers and destabilizes existing hierarchies. In China, 10 percent annual growth may be essential to the social contract, but slow growth does not — yet — seem to threaten the legitimacy of the state in Europe, North America, or Japan.

As Sam Gindin and Leo Panitch persuasively argue, even periodic crises are useful in maintaining the rule of money. They serve as reminders that the confidence of capital owners cannot be taken for granted. As Kalecki famously noted, the threat of a crisis when “business confidence” is shaken is a “powerful controlling device” for capitalists vis-à-vis the state. Too much success controlling crises is dangerous — it makes this threat less threatening.

So perhaps the most important thing about the Fed’s recent rate hike is that it’s a reminder that price stability and inflation management are always a pretext, or at best just one reason among others, for the managers of the capitalist state to control rapid growth and the potential gains for workers that follow. As the shifting justifications for restraining wage growth suggest, the republic of the central banker has always been run in the interests of money owners.

Some critics of the rate hike see it as a ploy to raise the profits of banks. In my opinion, this theory isn’t convincing. A better conspiracy theory is that it’s part of the larger project of keeping us all insecure and dependent on the goodwill of the owning class.

 

[1] The role of central banks in disguising the moment of conscious planning under capitalism and preserving the ideological fiction of spontaneous order is clearly visible in the way monetary policy is discussed by economists. From the concrete to the abstract. First, the “independent” status of central banks is supposed to place them outside the collective deliberation of democratic politics. Second, there is a constant attraction to the idea of a monetary policy “rule” that could be adopted once and for all, removing any element of deliberate choice even from the central bankers themselves. (Milton Friedman is only the best-known exponent of this idea, which is a central theme of discussion of central banks from the 18th century down to the present.) Third, in modern models, the “reaction function” of the central bank is typically taken as one of the basic equations of the model — the central bank’s reaction to a deviation of inflation from its chosen path has the same status as, say, the reaction of households to a change in prices. As Peter Dorman points out, there’s something very odd about putting policy inside the model this way. But it has the clear ideological advantage of treating the central bank as if it were simply part of the natural order of optimization by individual agents.

[2] The best analysis of the crisis of the 1970s in these terms remains Capitalism Since 1945, by Armstrong, Glyn and Harrison.

[3] The linked post by Peter Frase does an excellent job puncturing the bipartisan mythmaking around the Volcker and bringing out the centrality of his anti-labor politics. But it contains one important error. Frase describes the late-1970s crisis to which Volcker was responding as “capital refusing to invest, and labor refusing to take no for an answer.” The latter might be true but the former certainly is not: The late 1970s saw the greatest boom in business investment in modern US history; 1981 had the highest investment-GDP ratio since the records begin in 1929. High demand and negative real interest rates — which made machines and buildings more attractive than wealth in financial form — outweighed low profits, and investment boomed. (An oil boom in the southwest and generous tax subsidies also helped.) The problem Volcker was solving was not,as Frase imagines, that the process of accumulation was threatened by the refusal of unhappy money owners to participate. It was, in some ways, an even more threatening one — that real accumulation was proceeding fine despite the unhappiness of money owners. In the often-brilliant Buying Time, Wolfgang Streeck  makes a similar mistake.

[4] More precisely, it’s a return to what Anwar Shaikh calls the classical Phillips curve found in the Marxist literature, for instance in the form of Goodwin cycles. (The Shaikh article is very helpful in systematically thinking through alternative relationships between nominal wages, the wage share and inflation.)

[5] It’s worth noting that in these cases the ECB got what it wanted, or enough of it, and did aggressively intervene to stabilize government debt markets and the banking systems in almost all the crisis countries. As a result, the governments of Spain, Italy and Portugal now borrow more cheaply than ever in history. As I periodically point out, the direct cause of the crisis in Greece was the refusal of the ECB to extend it the same treatment. A common liberal criticism of the euro system is that it is too rigid, that it automatically applies a single policy to all its members even when their current needs might be different. But the reality is the opposite. The system, in the form of the ECB, has enormous discretion, and the crisis in Greece was the result of the ECB’s choice to apply a different set of policies there than elsewhere.

How Strong Is Business Investment, Really?

DeLong rises to defend Ben Bernanke, against claims that unconventional monetary policy in recent years has discouraged businesses from investing. Business investment is doing just fine, he says:

As I see it, the Fed’s open-market operations have produced more spending–hence higher capacity utilization–and lower interest rates–has more advantageous costs of finance–and we are supposed to believe that its policies “have hurt business investment”?!?! … As I have said before and say again, weakness in overall investment is 100% due to weakness in housing investment. Is there an argument here that QE has reduced housing investment? No. Is nonresidential fixed investment below where one would expect it to be given that the overall recovery has been disappointing and capacity utilization is not high?

As evidence, DeLong points to the fact that nonresidential investment as a share of GDP is back where it was at the last two business cycle peaks.

As it happens, I agree with DeLong that it’s hard to make a convincing case that unconventional monetary policy is holding back business investment. Arguments about the awfulness of low interest rates seem more political or ideological, based on the real or imagined interests of interest-receivers than any identifiable economic analysis. But there’s a danger of overselling the opposite case.

It is certainly true that, as a share of potential GDP, nonresidential investment is not low by historical standards. But is this the right measure to be looking at? I think not, for a couple of reasons, one relatively minor and one major. The minor reason is that the recent redefinition of investment by the BEA to include various IP spending makes historical comparisons problematic. If we define investment as the BEA did until 2013, and as businesses still do under GAAP accounting standards, the investment share of GDP remains quite low compared to previous expansions. The major reason is that it’s misleading to evaluate investment relative to (actual or potential GDP), since weak investment will itself lead to slower GDP growth. [1]

On the first point: In 2013, the BEA redefined investment to include a variety of IP-related spending, including the commercial development of movies, books, music, etc. as well as research and development. We can debate whether, conceptually, Sony making Steve Jobs is the same kind of thing as Steve Jobs and his crew making the iPhone. But it’s important to realize that the apparent strength of investment spending in recent expansions is more about the former kind of activity than the latter.  [2] More relevant for present purposes, since this kind of spending was not counted as investment — or even broken out separately, in many cases — prior to 2013, the older data are contemporary imputations. We should be skeptical of comparing today’s investment-cum-IP-and-R&D to the levels of 10 or 20 years ago, since 10 or 20 years ago it wasn’t even being measured. This means that historical comparisons are considerably more treacherous than usual. And if you count just traditional (GAAP) investment, or even traditional investment plus R&D, then investment has not, in fact, returned to its 2007 share of GDP, and remains well below long-run average levels. [3]

investment

More importantly, using potential GDP as the yardstick is misleading because potential GDP is calculated simply as a trend of actual GDP, with a heavier weight on more recent observations. By construction, it is impossible for actual GDP to remain below potential for an extended period. So the fact that the current recovery is weak by historical standards automatically pulls down potential GDP, and makes the relative performance of investment look good.

We usually think that investment spending the single most important factor in business-cycle fluctuations. If weak investment growth results in a lower overall level of economic activity, investment as a share of GDP will look higher. Conversely, an investment boom that leads to rapid growth of the economy may not show up as an especially high investment share of GDP. So to get a clear sense of the performance of business investment, its better to look at the real growth of investment spending over a full business cycle, measured in inflation-adjusted dollars, not in percent of GDP. And when we do this, we see that the investment performance of the most recent cycle is the weakest on record — even using the BEA’s newer, more generous definition of investment.

investmentcycles_broad
Real investment growth, BEA definition

The figure above shows the cumulative change in real investment spending since the previous business-cycle peak, using the current (broad) BEA definition. The next figure shows the same thing, but for the older, narrower GAAP definition. Data for both figures is taken from the aggregates published by the BEA, so it includes closely held corporations as well as publicly-traded ones. As the figures show, the most recent cycle is a clear outlier, both for the depth and duration of the fall in investment during the downturn itself, and even more for the slowness of the subsequent recovery.

investmentcycles_narrow
Real investment growth, plant and equipment only

Even using the BEA’s more generous definition, it took over 5 years for inflation-adjusted investment spending to recover its previous peak. (By the narrower GAAP definition, it took six years.) Five years after the average postwar business cycle peak, BEA investment spending had already risen 20 percent in real terms. As of the second quarter of 2015 — seven-and-a-half years after the most recent peak, and six years into the recovery — broad investment spending was up only 10 percent from its previous peak. (GAAP investment spending was up just 8.5 percent.) In the four previous postwar recoveries that lasted this long, real investment spending was up 63, 24, 56, and 21 percent respectively. So the current cycle has had less than half the investment growth of the weakest previous cycle. And it’s worth noting that the next two weakest investment performances of the ten postwar cycles came in the 1980s and the 2000s. In recent years, only the tech-boom period of the 1990s has matched the consistent investment growth of the 1950s, 1960s and 1970s.

So I don’t think it’s time to hang the “Mission Accomplished” banner up on Maiden Lane quite yet.

As DeLong says, it’s not surprising that business investment is weak given how far output is below trend. But the whole point of monetary policy is to stabilize output. For monetary policy to work, it needs to able to reliably offset lower than normal spending in other areas with stronger than normal investment spending. If after six years of extraordinarily stimulative monetary policy (and extraordinarily high corporate profits), business investment is just “where one would expect given that the overall recovery has been disappointing,” that’s a sign of failure, not success.

 

[1] Another minor issue, which I can’t discuss now, is DeLong’s choice to compare “real” (inflation-adjusted) spending to “real” GDP, rather than the more usual ratio of nominal values. Since the price index for investment goods consistent rises more slowly than the index for GDP as a whole, this makes current investment spending look higher relative to past investment spending.

[2] This IP spending is not generally counted as investment in the GAAP accounting rules followed by private businesses. As I’ve mentioned before, it’s problematic that national accounts diverge from private accounts this way. It seems to be part of a troubling trend of national accounts being colonized by economic theory.

[3] R&D spending is at least reported in financial statements, though I’m not sure how consistently. But with the other new types of IP investment — which account for the majority of it — the BEA has invented a category that doesn’t exist in business accounts at all. So the historical numbers must involve more than usual amount degree of guesswork.

Interest Rates and Bank Spreads

So the Fed decided not to raise rates this weeks. And as you’ve probably seen, this provoked an angry response from representatives of financial institutions. The owners and managers of money have been demanding higher interest rates for years now, and were clearly hoping that this week they’d finally start getting them.

As Paul Krugman points out, it’s not immediately obvious why money-owners are so hostile to low rates:

I’ve tried to understand demands that rates go up despite the absence of inflation pressure in terms of broad class interests. And the trouble is that it’s not at all clear where these interests lie. The wealthy get a lot of interest income, which means that they are hurt by low rates; but they also own a lot of assets, whose prices go up when monetary policy is easy. You can try to figure out the net effect, but what matters for the politics is perception, and that’s surely murky.

But, he has a theory:

What we should be doing …  is focusing not on broad classes but on very specific business interests. … Commercial bankers really dislike a very low interest rate environment, because it’s hard for them to make profits: there’s a lower bound on the interest rates they can offer, and if lending rates are low that compresses their spread. So bankers keep demanding higher rates, and inventing stories about why that would make sense despite low inflation.

I certainly agree with Krugman that in thinking about the politics of monetary policy, we should pay attention to the narrow sectoral interests of the banks as well as the broader interests of the owning class. But I’m not sure this particular story makes sense. What he’s suggesting is that the interest rate on bank lending is more strongly affected by monetary policy than is the interest rate on bank liabilities, so that bank spreads are systematically wider at high rates than at low ones.

This story might have made sense in the 1950s and 1960s, when bank liabilities consisted mostly of transactions deposits that paid no interest. But today, non-interest bearing deposits compose less than a quarter of commercial bank liabilities. Meanwhile, bank liabilities are much shorter-term than their assets (that’s sort of what it means to be a bank) so the interest rates on their remaining liabilities tend to move more closely with the policy rate than the interest rates on their assets. So it’s not at all obvious that bank spreads should be narrower when rates are low; if anything, we might expect them to be wider.

Luckily, this is a question we can address with data. Historically, have higher interest rates been associated with a wider spread for commercial banks, or a narrower one? Or have interest rate changes left bank spreads unchanged? To answer this, I looked at total interest income and total interest payments for commercial banks, both normalized by total assets. These are reported in a convenient form, along with lots of other data on commercial banks, in the FDIC’s Historical Statistics on Banking.

The first figure here shows annual interest payments and interest costs for commercial banks on the vertical axis, and the Federal funds rate on the horizontal axis. It’s annual data, 1955 through 2014. The gap between the blue and red points is a measure of the profitability of bank loans that year. [1] The blue and red lines are OLS regression lines.

Fig. 1: Commercial Bank Interest Paid and Received, as a Share of Assets, and the Federal Funds Rate

If Krugman’s theory were correct, the gap between the blue and red lines should be wider on the right, when interest rates are high, and narrower on the left, when they’re low. But in fact, the lines are almost exactly parallel. The gap between banks’ interest earnings and their funding costs is always close to 3 percent of assets, whether the overall level of rates is high or low. The theory that bank lending is systematically less profitable in a low-interest environment does not seem consistent with the historical evidence. So it’s not obvious why commercial banks should care about the overall level of interest rates one way or the other.

Here’s another way of looking at the same thing. Now we have interest received by commercial banks on the vertical axis, and interest paid on the horizontal axis. Again, both are scaled by total bank assets. To keep it legible, I’ve limited it to the years 1985-2014; anyway the earlier years are probably less relevant for today’s banking system. The diagonal line shows the average spread between the lending rate and the funding rate for this period. So points above the line are years when bank loans are unusually profitable, and points below are years when loans are less profitable than usual.

commbank2
Fig 2: Commercial Bank Interest Paid and Received, as a Percent of Assets

Here again, we see that there is no systematic relationship between the level of interest rates and the profitability of bank loans. Over the whole range of interest rates, spreads are clustered close to the diagonal. What we do see, though, is that the recent period of low interest rates has seen a steady narrowing of bank spreads. Since 2010, the average interest rate received by commercial banks has fallen by one full percentage point, while their average funding cost has fallen by a bit under half a point.

On the face of it, this might seem to support Krugman’s theory. But I don’t think it’s actually telling us anything about the effects of low interest rates as such. Rather, it reflects the fact that bank borrowing is much shorter term than bank lending. So a sustained fall in interest rates will always first widen bank spreads, and then narrow them again as lending rates catch up with funding costs. And in fact, the recent decline in bank spreads has simply brought them back to where they were in 2007. (Or in 1967, for that matter.) No doubt there are still a few long-term loans from the high-rate period that have not been refinanced and are still sitting profitably on banks’ books; but after seven years of ZIRP there can’t be very many. There’s no reason to think that continued low rates will continue to narrow bank spreads, or that higher rates will improve them. On the contrary, an increase in rates would almost certainly reduce lending profits initially, since banks’ funding rates will rise more quickly than their lending rates.

Now, on both substantive and statistical grounds, we might prefer to look at changes rather than levels. So the next two figures are the same as the previous ones, but using the year over year change rather than absolute level of interest rates. In the first graph, years with the blue above the red are years of widening spreads, while red above blue indicates narrowing spreads. In the second graph, the diagonal line indicates an equal change in bank lending and funding rates; points above the line are years of widening spreads, and points below the line are years of narrowing spreads. Again, I’ve limited it to 1985-2014.

Fig. 3: Year over Year Change in Commercial Bank Interest Received and Paid, as a Share of Assets, and the Federal Funds Rates

 

Fig. 4: Year over Year Change in Commercial Bank Interest Received and Paid, as a Share of Assets

 

Both figures show that rising rates are associated with narrower commercial bank spreads — that is, less profitable loans, not more profitable. (Note the steeper slope of the red line than the blue one in Figure 3.) Again, this is not surprising — since banks borrow short and lend long, their average funding costs change more quickly than their average lending rates do. The most recent three tightening episodes were all associated with narrower spreads, not wider ones. Over 2004-2006, banks’ funding costs rose by 1.5 points while the average rate on their loans rose by only 1.3 points. In 1999-2000, funding costs rose by 0.55 points while loan rates rose by 0.45 points. And in 1994-1996, bank funding costs rose by 0.6 points while loan rates rose by 0.4 points. Conversely, during the period of falling rates in 2007-2008, bank funding costs fell by 1.7 points while average loan rates fell by only 1.4 points. Admittedly, these are all rather small changes — what is most striking about banking spreads is their stability.  But the important thing is that past tightening episodes have consistently reduced the lending profits of commercial banks. Not increased them.

Thinking about the political economy of support for higher rates, as Krugman is doing, is asking the right question. And the idea that the narrow interests of commercial banks could be important here, is reasonable on its face. But the idea that higher rates are associated with higher lending spreads, just doesn’t seem to be supported by the data. Unfortunately, I don’t have a simple alternative story. As the late Bob Fitch used to say, 90 percent of what happens in the world can be explained by vulgar Marxism. But banks’ support for hard money may fall in the other 10 percent.

 

 

UPDATE: For what it’s worth, here are the results of regressions of average interest received by commercial banks and of and their average funding costs, on the Federal Funds rate. Both interest flows are normalized by total assets.

Full Period (1955-2014) 1955-1984 1985-2014
Coefficient r2 Coefficient r2 Coefficient r2
Funding 0.51 0.77 0.56 0.85 0.61 0.92
(0.04) (0.04) (0.03)
Lending 0.54 0.69 0.61 0.85 0.67 0.89
(0.05) (0.05) (0.04)
Funding 0.30 0.67 0.22 0.60 0.42 0.86
(0.03) (0.03) (0.03)
Lending 0.30 0.67 0.25 0.63 0.39 0.79
(0.03) (0.04) (0.04)

Again, we don’t see any support for the hypothesis that spreads systematically rise with interest rates. Depending on the period and on whether you look at levels or changes, you can see a slightly stronger relationship of the Federal Funds rate with either bank lending rates of funding costs; but none of these differences would pass a standard significance test.

Two positive conclusions come out of this. First, all the coefficients are substantially, and significantly, below 1. In other words,  the policy rate is passed through far from completely to market rates, even in the interbank market, which should be most closely linked to it. Second, looking at the bottom half of the table, we see that changes in the policy rate have a stronger affect on both the funding and lending rates (at least over a horizon of a year) today than they did in the postwar decades. This is not surprising, given the facts that non-interest-bearing deposits provided most bnk funding in the earlier period, and that monetary policy then worked through more limits on the quantity of credit than interest rates per se. But it’s interesting to see it so clearly in the data.

 

UPDATE 2: Krugman seems to be doubling down on the bank spreads theory. I hope he looks a bit at the historical data before committing too hard to this story.

 

VERY LATE UPDATE: In the table above, the first set of rows is levels; the second is year-over-year changes.

 

[1] This measure is not quite the same as the spread — for that, we would want to divide bank interest costs by their liabilities, or their interest-bearing liabilities, rather than their assets. But this measure, rather than the spread in the strict sense, is what’s relevant for the question we’re interested in, the effect of rate changes on bank lending profits. Insofar as bank loans are funded with equity, lending will become more profitable as rates rise, even if the spread is unchanged. For this reason, I refer to banks average funding costs, rather than average borrowing costs.

Mixed Messages from The Fed and the Bond Markets

It’s conventional opinion that the Fed will begin to raise its policy rate by the end of 2015, and continue raising rates for the next couple years. In the FT, Larry Summers argues that this will be a mistake. And he observes that bond markets don’t seem to share the conventional wisdom: “Long term bond markets are telling us that real interest rates are expected to be close to zero in the industrialised world over the next decade.”

The Summers column inspired me to take a look at bond prices and flesh out this observation. It is straightforward to calculate how much the value of a bond change in response to a change in interest rates. So by looking at the current yields on bonds of different maturities, we can see what expectations of future rate changes are consistent with profit-maximizing behavior in bond markets. [1]

The following changes shows the yields of Treasury bonds of various maturities, and the capital loss for each bond from a one-point rise in yield over the next year. (All values are in percentage points.)

Maturity Yield as of July 2015 Value Change from 1-Point Rise
30 year 3.07 -17.1
20 year 2.77 -13.9
10 year 2.32 -8.4
5 year 1.63 -4.6
1 year 0.30 -0.0

So if the 30-year rate rises by one point over the next year, someone who just bought a 30-year bond will suffer a 17 percent capital loss.

It’s clear from these numbers that Summers is right. If, over the next couple of years, interest rates were to “normalize” to their mid-90s levels (about 3 points higher than today), long bonds would lose half their value. Obviously, no one would hold bonds at today’s yields if they thought there was an appreciable chance of that happening.

We can be more precise. For any pair of bonds, the ratio of the difference in yields to the difference in capital losses from a rate increase, is a measure of the probability assigned by market participants to that increase. For example, purchasing a 20-year bond rather than a 30-year bond means giving up 0.3 percentage points of yield over the next year, in return for losing only 14 percent rather than 17 percent if there’s a general 1-point increase in rates. Whether that looks like a good or bad tradeoff will depend on how you think rates are likely to change.

For any pair of bonds, we can calculate the change in interest rates (across the whole yield curve) that would keep the overall return just equal between them. Using the average yields for July, we get:

30-year vs 20-year: +0.094%

30-year vs. 10-year: +0.086%

30-year vs. 5-year: +0.115%

20-year vs. 10-year +0.082%

20-year vs. 5 year: + 0.082%

Treasury bonds seem to be priced consistent with an expected tenth of a percent or so increase in interest rates over the next year.

In other words: If you buy a 30 year bond rather than a 20-year one, or a 20-year rather than 10-year, you will get a higher interest rate. But if it turns out that market rates rise by about 0.1 percentage points (10 basis points) over the next year, the greater capital losses on longer bonds will just balance their higher yields. So if you believe that interest rates in general will be about 10 basis points higher a year from now than they are now, you should be just indifferent between purchasing Treasuries of different maturities. If you expect a larger increase in rates, long bonds will look overpriced and you’ll want to sell them; if you expect a smaller increase in rates than this, or a decrease, then long bonds will look cheap to you and you’ll want to buy them. [2]

A couple of things to take from this.

First, there is the familiar Keynesian point about the liquidity trap. When long rates are low, even a modest increase implies very large capital losses for holders of long bonds. Fear of these losses can set a floor on long rates well above prevailing short rates. This, and not the zero lower bound per se, is the “liquidity trap” described in The General Theory.

Second,  compare the implied forecast of a tenth of a point increase in rates implied by today’s bond prices, to the forecasts in the FOMC dot plot. The median member of the FOMC expects an increase of more than half a point this year, 2 points by the end of 2016, and 3 points by the end of 2017. So policymakers at the Fed are predicting a pace of rate increases more than ten times faster than what seems to be incorporated into bond prices.

FOMC dotplot

If the whole rate structure moves in line with the FOMC forecasts, the next few years will see the biggest losses in bond markets since the 1970s. Yet investors are still holding bonds at what are historically very low yields. Evidently either bond market participants do not believe that Fed will do what it says it will, or they don’t believe that changes in policy rate will have any noticeable effect on longer rates.

And note: The belief that long rates unlikely to change much, may itself prevent them from changing much. Remember, for a 30-year bond currently yielding 3 percent, a one point change in the prevailing interest rate leads to a 17 point capital loss (or gain, in the case of a fall in rates). So if you have even a moderately strong belief that 3 percent is the most likely or “normal” yield for this bond, you will sell or buy quickly when rates depart much from this. Which will prevent such departures from happening, and validate beliefs about the normal rate. So we shouldn’t necessarily expect to see the whole rate structure moving up and down together. Rather, long rates will stay near a conventional level (or at least above a conventional floor) regardless of what happens to short rates.

This suggests that we shouldn’t really be thinking about a uniform shift in the rate structure. (Though it’s still worth analyzing that case as a baseline.) Rather, an increase in rates, if it happens, will most likely be confined to the short end. The structure of bond yields seems to fit this prediction. As noted above, the yield curve at longer maturities implies an expected rate increase on the order of 10 basis points (a tenth of a percentage point), the 10-year vs 5 year, 10 year vs 1 year, and 5 year vs 1 year bonds imply epected increases of 18, 24 and 29 basis points respectively. This is still much less than dot plot, but it is consistent with idea that bond markets expect any rate increase to be limited to shorter maturities.

In short: Current prices of long bonds imply that market participants are confident that rates will not rise substantially over the next few years. Conventional wisdom, shared by policymakers at the Fed, says that they will. The Fed is looking at a two point increase over the next year and half, while bond rates imply that it will take twenty years. So either Fed won’t do what it says it will, or it won’t affect long rates, or bondholders will get a very unpleasant surprise. The only way everyone can be right is if trnasmission from policy rate to long rates is very slow — which would make the policy rate an unsuitable tool for countercyclical policy.

This last point is something that has always puzzled me about standard accounts of monetary policy. The central bank is supposed to be offsetting cyclical fluctuations by altering the terms of loan contracts whose maturities are much longer than typical business cycle frequencies. Corporate bonds average about 10 years, home mortgages, home mortgages of course close to 30. (And housing seems to be the sector most sensitive to policy changes.) So either policy depends on systematically misleading market participants, to convince them that cyclical rate changes are permanent; or else monetary policy must work in some completely different way than the familiar interest rate channel.

 

 

[1] In the real world things are more complicated, both because the structure of expectations is more complex than a scalar expected rate change over the next period, and because bonds are priced for their liquidity as well as for their return.

[2] I should insist in passing, for my brothers and sisters in heterodoxy, that this sort of analysis does not depend in any way on “consumers” or “households” optimizing anything, or on rational expectations. We are talking about real markets composed of profit-seeking investors, who certainly hold some expectations about the future even if they are mistaken.

Draghi Makes His Case

A few unorganized thoughts on yesterday’s press conference. Video is here. Transcript is … do they even publish transcripts of these things?

Draghi’s introductory remarks didn’t mention Greece but of course that’s what all the questions were about. The big question were about liquidity assistance (ELA) to Greek banks and under what conditions Greek debt would be included in quantitative easing, a big expansion of which was just announced.

There’s no way to hide the hypocrisy of the simultaneous expansion of QE and continued limits on ELA. You can say, the markets don’t want to hold this debt so we need to reduce our holdings too, to avoid excessive risk — then you are acting like a private bank. Or you can say, the markets don’t want to hold this debt so we need to increase our holdings, to keep its yield down — then you are acting like a central bank. But there’s no basis for applying one of these logics to Greece and the other to the rest of the euro area.

There was also no explanation for the decision to raise the ELA cap by 900 million. Draghi kept repeating the formula “solvent banks with adequate collateral” but obviously this implies a bank by bank assessment, not a hard cap for the country as a whole. Anyway, the logic of a lender of last resort is that, if you are going to support the banks, you need to be prepared to lend as much as it takes. A limited program only makes the problem worse, by encouraging depositors and other holders of short-term liabilities to get out before its exhausted. Paul de Grauwe has the right analysis here:

The correct announcement of the ECB should be that it will provide all the necessary liquidity to the Greek banks. Such an announcement will pacify depositors. Knowing that the banks have sufficient cash to pay them out they will stop running to the bank. Like the OMT, such an announcement will stop the banking crisis without the ECB actually having to provide much liquidity to the Greek banks.

These are first principles of how a central bank should deal with a banking crisis. I would be very surprised if the very intelligent men (and one woman) in Frankfurt did not know these first principles. This leads me to conclude that the ECB has other objectives than stabilizing the Greek banking system. These objectives are political. The ECB continues to put pressure on the Greek government to behave well. The price of this behavior by the ECB is paid by millions of Greeks.

Logically, ELA should either be ended or else provided on the a sufficient scale to restore confidence and end the run. Draghi suggested that there was something moderate and “proportional” about choosing a course in between, but this is incoherent. I was also very struck that he felt the need to reject the accusation that “there was bank run deliberately caused by the ECB,” which no one there had made. Remember that old line, attributed to Claud Cockburn: Never believe something until it’s been officially denied.

Another thing I found interesting was how much he treated the Bank of Greece as an independent actor, frequently referring to decisions “taken by the ECB and the Bank of Greece” and even trying to pass the buck to them on questions like whether the additional ELA was sufficient (“we have fully accommodated the Bank of Greece’s request”) and when the Greek banks would be able to reopen. Establishing that the national central banks have independent authority will be important if they become a terrain of struggle in future conflicts between popular governments and the euro authorities.

On the question of when the Greek banks would reopen, after deferring to the BoG, he then said that they hold all this government paper (which isn’t actually true — the ECB’s own numbers show that Greek banks have the lowest proportion of government loans on their books of any major euro-area country) and their solvency and the adequacy of their collateral therefore depend on what’s going on with the government. “The quality of the collateral depends on the quality of the discussions” with the creditors was one way he put it, a more or less explicit acknowledgement that this decision is being made on political criteria.

Someone asked him point-blank how the Greek banks could be ineligible for assistance when the ECB’s own analysis had concluded they were solvent; someone else asked why a hard cap was being announced when this was never done for individual banks, precisely because of concerns wit would intensify a panic. At this point (around 40:00 in the video) he changed tack again. Now he said that this was a special case because it wasn’t about conditions at individual banks but about a “systemic” problem of a whole banking system, so the old rules didn’t apply. Which of course made nonsense of the “solvency and adequate collateral” formula, without doing anything to justify the ECB’s actions.

On the question of whether or when Greek bonds would be included in QE, Draghi’s initial non-answer was “when they become eligible for monetary policy.” Pressed by the reporter (around 56:00), he turned to vice-president Constâncio, who explained that if a country’s bonds were rated below investment-grade, they could only be purchased by the ECB if (1) there was an IMF program in place and (2) the ECB’s Governing Council determines that there is “credible compliance” with the program. [1] Here again we see how monetary policy is used to advance a particular policy agenda, and more broadly, a nice illustration of how market and state power articulate. The supposed judgement of the markets is actually enforced by public agencies.

One of the few departures from Greece was when Draghi got going — I can’t remember in response to what — about the need for deeper “capital market integration.” Which seems nuts. Who, looking at the situation in Europe today, would say, You know what we really need? More uncontrolled international lending. It’s just like Dani Rodrik’s parable:

Imagine landing on a planet that runs on widgets. You are told that international trade in widgets is highly unpredictable and volatile on this planet, for reasons that are poorly understood. A small number of nations have access to imported widgets, while many others are completely shut out even when they impose no apparent obstacles to trade. With some regularity, those countries that have access to widgets get too much of a good thing, and their markets are flooded with imported widgets. This allows them to go on a widget binge, which makes everyone pretty happy for a while. However, such binges are often interrupted by a sudden cutoff in supply, unrelated to any change in circumstances. The turnaround causes the affected economies to experience painful economic adjustments. For reasons equally poorly understood, when one country is hit by a supply cutback in this fashion, many other countries experience similar shocks in quick succession. Some years thereafter, a widget boom starts anew.

Your hosts beg you for guidance: how should they deal with their widget problem? Ponder this question for a while and then ponder under what circumstances your central recommendation would be that all extant controls on international trade in widgets be eliminated.

 

[1] I’m not sure but I believe these standards were established by the ECB itself, and not by any of its governing legislation. So the answer is evasive in another way. In general, watching these things makes clear how helpful it is in resisting popular pressure to have multiple, shifting, overlapping authorities. Any decision can be presented as an objective constraint imposed from somewhere else.

 

UPDATE: Nathan Tankus has some very sharp observations on the press conference.

 

The Non-Accelerating What Now Rate of Inflation

The NAIRU is back. Here’s Justin Wolfers in the Times the other day:

My colleague Neil Irwin wrote about this slow wage growth as if it were bad news. I feel much more optimistic. … It is only when nominal wage growth exceeds the sum of inflation (about 2 percent) and productivity growth (about 1.5 percent) that the Fed needs to be concerned…

Read that last sentence again. What is it that would be accelerating here?

The change in the wage share is equal to the increase in average nominal wages, less inflation and the increase in labor productivity. This is just accounting. So Wolfer’s condition, that wage growth not exceed the sum of inflation and labor productivity growth is, precisely, the condition that the wage share not rise. If we take him literally — and I don’t see why we shouldn’t — then the Fed should be less concerned to raise rates when inflation is higher. Which makes no sense if the goal is to control inflation. But perfect sense if the real concern is to prevent a rise in the wage share.

Four Questions about Fiscal Policy

Earlier this fall, I spent a pleasant few days at the 12th Post Keynesian Conference in Kansas City, including a long chat over beers with Robert Skidelsky. In addition to presenting some of my current work, I took part in an interesting roundtable discussion of functional finance with Steve Fazzari, Peter Skott, Marc Lavoie and Mario Seccarechia. Here is an edited version of what I said.

* * *

We all agree that fiscal policy is effective. If output is too low, by whatever standard, higher public spending or lower taxes will cause it to rise. And we all agree that the current level of public debt has no implications for the feasibility or desirability of fiscal policy, at least in a country like the United States. In the wider world that might be a controversial statement but in this room it is not.

It’s not productive to repeat points on which we all agree. So instead, I want to pose four questions about functional finance on which there is not a consensus. These aren’t questions I necessarily have (or expect to hear) good answers to at the moment, but ones that I hope will be the focus of future work. First, the political economy question. Why does the idea of a government financial constraint have such a tenacious hold on both the policy conversation and the economics profession? What function, what interest, does this idea serve? Second, how confident are we about the level of aggregate expenditure that policy should target? Is there a well-defined level of potential output that corresponds to both full employment and price stability? Third, what is the problem that we imagine fiscal policy to be solving? Is it stabilizing of output in the face of “shocks” of some kind, or is it adjusting the long term trend? And what are the sources for the variation in private demand to which policy must respond? Finally, if functional finance means that fiscal policy replaces monetary policy as the main tool for managing aggregate expenditure, what role does that leave for the interest rate?

1. The political economy question.  We all agree that in a country like the modern United States (or the EU as a whole), public budgets are never constrained by the willingness of the private sector to hold the government’s liabilities. There are a number of routes, both logical and empirical, to reach this conclusion, which I won’t repeat here. And yet both policymakers and academic economists are, with few exceptions, committed to the idea that government does face a financial constraint. I don’t think it’s a sufficient explanation that people are just stupid. I was on an earlier panel with Randy Wray, where he quoted Paul Samuelson describing the idea of a government financial constraint as “religion” that has no rational basis but is nonetheless “scares people … into behaving the way that civilized life requires.” [1] Randy focused, understandably, on the first half of that quote, the acknowledgement that a balanced budget is desirable only on ritual or aesthetic criteria. But what about the second part? What is the civilized life that benefits from this taboo?

The political salience of the balanced-budegt myth has been particularly clear in the debt-ceiling fights of the past few years.  You read John Cassidy in New Yorker: “Every country needs to pay its creditors or face ruin.” [2] This is framed as a statement of fact, but it really describes a political project. Creditors need to threaten countries with ruin if they are going to be obeyed. The threat doesn’t have to be real, but it does have to be believed.

The most important political use of the government budget constraint today is undoubtedly in the Euro area, where it seems clear that a central part of the elite motivation for the single currency was precisely to reimpose financial constraints on national governments. This view of the euro project was forcefully expressed by Massimo Pivetti in a 2013 article in Contributions to Political Economy. As he puts it, the ultimate effect of European countries’ renunciation of monetary sovereignty has been the dismantling of the social democratic order.

What is being liquidated is but one of the most advanced experiences of civil coexistence the world has ever known—in fact, the greatest ever achievement of the bourgeois civilization. … 

Surrender of national sovereignty in the monetary and fiscal fields subscribed by European governments produced a situation of political ‘irresponsibility’, which greatly facilitated their declining commitment to high employment and the redistribution of income, as well as the priority given to reducing inflation, the gradual dismantling of the welfare state, and the privatization drive. …  [The euro] is an infernal machine: a machine born out of a deliberate continental project to undermine wage earners’ bargaining powers.

Wolfgang Streeck similarly argues that policies that result in rising debt are not the result of rising demands for redistribution and public services, but rather have been supported by the wealthy, precisely because “rising public debt can be utilized politically to argue for cutbacks in state spending and for privati­zation of public services.” You can find similar arguments by Perry Anderson (in The New Old World), Gindin and Panitch, and others. Financial constraint “disciplines” “irresponsible” policymakers — in other words, it makes them responsive to the interests of owners of financial assets. And I would stress the same fundamental point emphasized by Gindin and Panitch — the interest that counts here is not a direct pecuniary interest, defined within the economic system. It is the interest of wealthowners as a class in the perpetuation of a social order based on the accumulation of private wealth.

2. Next, I think we need to interrogate the notion of potential output more critically. The assumption of almost the entire functional finance literature — including my own work — is that there is a well-defined level of aggregate expenditure that policy should be targeting, which corresponds to full employment and full utilization of society’s resources. In the standard formula, once we see rising inflation, we know that this target has been reached and there should be no further expansionary policy. In this respect, there is no difference between functional finance and mainstream policy thought. The difference is about the tools used, not about the goal. Most importantly, both policy orthodoxy and functional finance assume that neither inflation nor employment is affected directly by macroeconomic policy, but only via the level of output. So output, inflation and employment can be treated as three indicators for a single target. [3]

It is not obvious, though, why the goals of full employment, price stability and steady output growth should always coincide. Now, in practice it may be that they generally do, or at least are close enough that this is not a big problem. One thing Arjun and I do in our paper is examine this question directly. We compute a number of different measures of the output gap from 1953 to the present. We compare output gaps based on the deviation of current output from trend, the level of unemployment, the level of inflation, and the change in inflation, as well as a measure combining unemployment and the change in inflation that corresponds to the Taylor rule. The interesting thing is that these different measures perform very similarly. The output and unemployment measures fit especially closely, with a simple correlation coefficient of 0.94.  In other words, the Okun relationship between output and unemployment is very stable, and the Phillips curve relationship between output or employment and inflation is also fairly stable. So the statement “When output is above trend, you will see rising inflation; when output is below trend, you will see high unemployment” does in fact seem to be a reliable generalization. (See figure below.)

The figure shows measures of the difference between current output and potential based on (1) trend GDP, as computed by the BEA; (2) the deviation of unemployment from its long-term average; (3) the average of the deviations of unemployment and inflation from their long-term averages; (4) the average of the deviation of unemployment from average and the year-over-year change in inflation; and (5) the year-over-year change in inflation. 

But even if these measures agree with each other for the US over the past 60 years, that doesn’t mean they will agree in other times and places. And in fact, we see that the inflation-change measure does not agree with the others for the post-2007 period, suggesting a much smaller negative output gap. (This is because inflation has stabilized at a low level, rather than continuing to fall.) And even if these measures do generally agree with each other, that doesn’t mean they are right, or that interpreting them is straightforward. In particular, we should ask if hysteresis might not be a more general phenomenon, and that the inflation that comes with output above potential isn’t better thought of as an adjustment cost. This brings me to the next question.

3. Is aggregate demand only an issue in the short run, or does it matter in the long run as well? In other words, is the problem to be solved by policy deviations of output around a trend that is determined on the supply side, or is the trend itself the object of policy?

If the former, shouldn’t we have a more positive theory about what these “shocks” are that policy is responding to. This has always struck me as one of the weirdest lacunae in mainstream macro. The entire problem of policy in this framework is responding to these shocks, so you would think that a central question would be where they come from, how large they are, whether there are identifiable factors that affect their distribution. But instead the existence of these vaguely defined “shocks” is just the unquestioned starting point of analysis. Now obviously there are reasons for this. Shocks, by definition, are changes in the state of the world that are not due to rational optimization, so if that’s your methodology, then “shocks” just means “things I have nothing to say about.” (And I have a sneaking suspicion that there is a logical inconsistency between the existence of unanticipated shocks and the idea of intertemporal equilibrium. But maybe not.) But on our side we don’t have that excuse. We shouldn’t limit ourselves to showing that changes in the government budget position can offset changes in desired private spending. We should try to explain why desired private spending varies so dramatically.

And what if demand matters in the long run, thanks to hysteresis (and what I call anti-hysteresis) in the laborforce, and Verdoorn-Kaldor changes in productivity growth? [4] In that case these questions are even more urgent. And we also have to face the political question that was banished from respectable macro in the 1980s: What is the desirable tradeoff between output and inflation? More broadly, if we can’t take a given path of potential output as given, how do we define the goals of macro policy?

4. What is the role of interest rate policy in a functional finance framework, given that it is no longer the primary tool for adjusting aggregate expenditure? On Thursday’s panel, we had three different answers to this question. Arjun and I say that if for whatever reason the public debt to GDP ratio is a concern for policymakers, adjusting the policy interest rate is in general sufficient to stabilize that ratio at some desired level. Peter Skott says that if we have some idea of the optimal long-run capital-output ratio (or perhaps more precisely, the optimal choice of technique), the interest rate can be set to achieve that. And Randy says that we shouldn’t worry about the debt-GDP ratio and that business investment decisions are not very responsive to the interest rate, so its main consequences are distributional. Since there is no social interest in providing a passive, risk-free income to rentiers, the nominal interest rate should be set to zero permanently.

[1] The quote is from an interview with Mark Blaug:  “I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked [that] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires.”

[2] The title of the piece is “Why America Needs a Stock Market Crash.”

[3] This isn’t strictly correct, since an important component of functional finance in its modern UMKC form is a job guarantee or employer of last resort (ELR) policy. But given the stability of the Okun relationship, employment and output can safely be treated as a single target in practice. The problem is the relationship of employment and output, on the one hand, with inflation, on the other.

[4] As late as the 1980s, people like Tobin took it for granted that the reason that inflationary or deflationary gaps would not continue indefinitely, was that aggregate supply would adjust.

Five Thoughts on Monetary Policy

1. Monetary policy may operate on (a) the quantity of bank liabilities (money); (b) the quantity of bank assets (credit); (c) the price of one or more assets relative to money (an interest rate);  and/or (d) the price of money, normally relative to some other money (an exchange rate). Which of these should be considered the most immediate target of central bank policy, both practically and conceptually, has been debated for over 200 years. All four positions are well-represented in both academic literature and central bank policymaking. For the US over the past 50 years, you could say that the center of gravity — both in policy and in the economics profession — has shifted from the quantity of credit to the quantity of money, and then from the quantity of money to the price of credit. [*] I don’t know of any good historical account of these recent shifts, but they come through dramatically if you compare contemporary articles on monetary policy, ones from 20 years ago, and ones from 50 years ago.

Lance Taylor has a good discussion of the parallel debates in the 19th century on pages 68-84 of Maynard’s Revenge, and a somewhat more technical version in chapter 3 of Reconstructing Macroeconomics. Below, I reproduce his table classifying various early monetary theorists in the four categories above, and on the orthogonal dimension of whether the money/credit system is supposed to be active or passive with respect to the economy. Obviously, confidence about the usefulness of monetary policy implies a position on the lower half of the table.

From Lance Taylor, Reconstructing Macroeconomics

It would be foolish to debate which of these positions is the correct one — though the monetarist view that the quantity of money plays an important causal role is clearly inapplicable to modern economies. It also seems possible that we may be seeing a shift away from the focus on the price of credit, and specifically the single policy interest rate — a position that is presented in many recent textbooks as the only possible one, even though it has been dominant only since the 1990s. In general what we should be doing is recognizing the diversity of positions and exploring the historical contexts in which one or another comes to dominate.

2. Regardless of which margin it operates on, monetary policy in its modern sense typically targets a level of aggregate output. This means changing how tightly liquidity constraints bind current expenditure. In other words, how easy is it for a unit that wants to increase its spending to acquire money, either by selling additional current output, selling an asset, or issuing a new liability? So regardless of the immediate target of monetary policy, the intermediate target is liquidity. (So what’s the point? The point is liquidity. The point is liquidity. The point is liquidity.) This may seem obvious, but keeping this idea in mind helps, I think, to cut through a lot of confusion. Expansionary policy makes it easier for someone to finance increased spending relative to income. Contractionary policy makes it harder.

3. Orthodox macroeconomics confuses the issue by assuming a world of infinite liquidity, where anyone can spend as much they like in any given period, subject to an intertemporal budget constraint that their spending over the infinite future must equal their income over that same infinite future. This condition — or equivalently the transversality or no-Ponzi condition — is coherent as a property of mathematical model. But  it is meaningless as applied to observable economic behavior. The only way my spending over my whole lifetime can be limited, is if my spending in some particular period is limited. Conversely, if I can spend as much as I want over any finite horizon, then logically I can spend as much as I want over an infinite horizon too. The orthodox solution is literally to just add an assumption saying “No you can’t,” without any explanation for where this limitation comes from. In reality, any financial constraint that rules out any trajectory of lifetime spending in excess of lifetime income will rule out some trajectories in which lifetime spending is less than lifetime income as well.

More concretely, orthodox theory approaches monetary policy through the lens of a consumption loan, in which the interest rate represents not the terms on which increased expenditure today can be financed, but the terms on which expenditure today trades off against expenditure in the future. In reality, consumption loans — while they do exist — are a very small fraction of total debt. The vast majority of private loans are taken to finance assets, which are expected to be income-positive. The models you find in graduate textbooks, in which the interest rate reflects a choice between consumption now and consumption later, have zero connection with real-world interest rates. The vast majority of loans are incurred to acquire an asset whose return will exceed the cost of the loan. So the expectation is that spending in the future will be higher, not lower, as a result of borrowing today. And of course nobody in the policy world believes in consumption loans or the interest rate as an intertemporal price or the intertemporal budget constraint or any of that. (Just compare Bernanke’s article on “The Credit Channel of Monetary Policy Transmission” with Woodford’s Interest and Prices, the most widely used New Keynesian graduate textbook. These are both “mainstream” economists, but there is zero conceptual overlap.) If you are not already stuck in the flybottle of academic economics there is no reason to worry about this stuff. Interest is not the price of consumption today vs. consumption tomorrow, it’s the price of money or of liquidity.

4. The fundamental tradeoff in the financial system is between flexibility and stability. The capacity of the financial system to delink expenditure from income is the whole point of it but also why it contributes to instability. Think of it this way: The same flexibility that allows an entrepreneur to ignore market signals to introduce a new product or process, allow someone to borrow money for a project that will never pay off. In general, it’s not clear until after the fact which is which. Monetary reforms respond to this tension by simultaneously aiming at making the system more rigid and at making it more flexible. This fundamental conflict is often obscured by the focus on specific mechanisms and by fact that same person often wants both. Go back to Hume, who opposed the use of bank-credit for payments and thought a perfect circulation was one in which the quantity of money was just equal to the amount of gold. But who also praised early banks for allowing merchants to “coin their whole wealth.”

You could also think of liquidity as providing a bridge for expenditure over dips in income. This is helpful when the fall is short-term — the existence of liquidity avoids unnecessary fluctuations in spending (and in aggregate income). But it is a problem when the fall is lasting — eventually, expenditure will have to confirm, and putting the adjustment off makes it larger and more disruptive when it comes. This logic is familiar in the business press, applied in particular, in a moralizing way, to public debt. But the problem is more general and doesn’t admit of a general solution. A more flexible credit system smooths over short-term fluctuations but allows more dangerous long-term imbalances to develop. A more rigid system prevents the development of any large imbalances but means you feel every little bump right up your spine.


(EDIT: On Twitter, Steve Randy Waldman points out that the above paragraph sits uncomfortably with my rejection of the idea of consumption loans. I should probably rewrite it.)
5. Politically, the fundamental fact about monetary policy is that it is central planning that cannot speak its name. The term “natural interest rate” was introduced by Wicksell, introduced to the English-speaking world by Hayek, and reintroduced by Friedman to refer specifically to the interest rate set by the central bank. It becomes necessary to assert that the interest rate is natural only once it is visibly a political question. And this isn’t only about the rhetoric of economics: Practical monetary policy continues to be constrained by the need for the outcome of policy choices to be disguised in this way.

Mike Konczal has a good discussion of how this need to maintain the appearance of “natural”market outcomes has hamstringed policy since 2008.

Starting in December 2012, the Federal Reserve started buying $45 billion a month of long-term Treasuries. Part of the reason was to push down the interest rates on those Treasuries and boost the economy. But what if the Fed … had picked a price for long-term securities, and then figured out how much it would have to buy to get there? Then it would have said, “we aim to set the 10-year Treasury rate at 1.5 percent for the rest of the year” instead of “we will buy $45 billion a month of long-term Treasuries.” This is what the Fed does with short-term interest rates… 

What difference would this have made? The first is that it would be far easier to understand what the Federal Reserve was trying to do over time. … The second is that it might have been easier. … the markets are unlikely to go against the Fed … the third is that if low interest rates are the new normal, through secular stagnation or otherwise, these tools will need to be formalized. … 

The normal economic argument against this is that all the action can be done with the short-rate. … the real argument is political. … the Federal Reserve would be accused of planning the economy by setting long-term interest rates. So it essentially has to sneak around this argument by adjusting quantities. … As Greta R. Krippner notes in her excellent Capitalizing on Crisis, in 1982 Frank Morris of the Boston Fed argued against ending their disaster tour with monetarism by saying, “I think it would be a big mistake to acknowledge that we were willing to peg interest rates again. The presence of an [M1] target has sheltered the central bank from a direct sense of responsibility for interest rates.” 

I agree with Mike: The failure of the Fed to announce a price target for long bonds is a clear sign of the political limits to monetary policy. (Keynes, incidentally, came to support fiscal policy only after observing the same constraints on the Bank of England in the 1920s.) There is a profound ideological resistance to acknowledging that monetary policy is a form of planning. For a vivid example of this ideology in the wild, just go to the FRED website and look up the Federal Funds rate. Deciding on the level of the Fed Funds rate is the primary responsibility of the Federal Reserve, it’s the job of Janet Yellen and the rest of the FOMC. But according to the official documentation, this rate is “essentially determined by the market” and merely “influenced by the Federal Reserve.” There is a profound resistance, inscribed right in the data, to the idea that interest rates are consciously chosen consciously rather than somehow determined naturally in the market.

[*] This is a better description of the evolution of monetary theory than the evolution of monetary policy. It might be more accurate to say that policy went directly from targeting the quantity of credit to the price of credit, with the transitional period of attention to monetary aggregates just window dressing.

Alvin Hansen on Monetary Policy

The more you read in the history of macroeconomics and monetary theory, the more you find that current debates are reprises of arguments from 50, 100 or 200 years ago.

I’ve just been reading Perry Mehrling’s The Money Interest and the Public Interest, which  is one of the two best books I know of on this subject. (The other is Arie Arnon’s Monetary Theory and Policy Since David Hume and Adam Smith.) About a third of the book is devoted to Alvin Hansen, and it inspired me to look up some of Hansen’s writings from the 1940s and 50s. I was especially struck by this 1955 article on monetary policy. It not only anticipates much of current discussions of monetary policy — quantitative easing, the maturity structure of public debt, the need for coordination between the fiscal and monetary policy, and more broadly, the limits of a single interest rate instrument as a tool of macroeconomic management — but mostly takes them for granted as starting points for its analysis. It’s hard not to feel that macro policy debates have regressed over the past 60 years.

The context of the argument is the Treasury-Federal Reserve Accord of 1951, following which the Fed was no longer committed to maintaining fixed rates on treasury bonds of various maturities. [1] The freeing of the Fed from the overriding responsibility of stabilizing the market for government debt, led to scholarly and political debates about the new role for monetary policy. In this article, Hansen is responding to several years of legislative debate on this question, most recently the 1954 Senate hearings which included testimony from the Treasury department, the Fed Board’s Open Market Committee, and the New York Fed.

Hansen begins by expressing relief that none of the testimony raised

the phony question whether or not the government securities market is “free.” A central bank cannot perform its functions without powerfully affecting the prices of government securities.

He then expresses what he sees as the consensus view that it is the quantity of credit that is the main object of monetary policy, as opposed to either the quantity of money (a non-issue) or the price of credit (a real but secondary issue), that is, the interest rate.

Perhaps we could all agree that (however important other issues may be) control of the credit base is the gist of monetary management. Wise management, as I see it, should ensure adequate liquidity in the usual case, and moderate monetary restraint (employed in conjunction with other more powerful measures) when needed to check inflation. No doubt others, who see no danger in rather violent fluctuations in interest rates (entailing also violent fluctuations in capital values), would put it differently. But at any rate there is agreement, I take it, that the central bank should create a generous dose of liquidity when resources are not fully employed. From this standpoint the volume of reserves is of primary importance.

Given that the interest rate is alsoan object of policy, the question becomes, which interest rate?

The question has to be raised: where should the central bank enter the market -short-term only, or all along the gamut of maturities?

I don’t believe this is a question that economists asked much in the decades before the Great Recession. In most macro models I’m familiar with, there is simply “the interest rate,” with the implicit assumption that the whole rate structure moves together so it doesn’t matter which specific rate the monetary authority targets. For Hansen, by contrast, the structure of interest rates — the term and “risk” premiums — is just as natural an object for policy as the overall level of rates. And since there is no assumption that the whole structure moves together, it makes a difference which particular rate(s) the central bank targets. What’s even more striking is that Hansen not only believes that it matters which rate the central bank targets, he is taking part in a conversation where this belief is shared on all sides.

Obviously it would make little difference what maturities were purchased or sold if any change in the volume of reserve money influenced merely the level of interest rates, leaving the internal structure of rates unaffected. … In the controversy here under discussion, the Board leans toward the view that … new impulses in the short market transmit themselves rapidly to the longer maturities. The New York Reserve Bank officials, on the contrary, lean toward the view that the lags are important. If there were no lags whatever, it would make no difference what maturities were dealt in. But of course the Board does not hold that there are no lags.

Not even the most conservative pole of the 1950s debate goes as far as today’s New Keynesian orthodoxy that monetary policy can be safely reduced to the setting of a single overnight interest rate.

The direct targeting of long rates is the essential innovation of so-called quantitative easing. [2] But to Hansen, the idea that interest rate policy should directly target long as well as short rates was obvious. More than that: As Hansen points out, the same point was made by Keynes 20 years earlier.

If the central bank limits itself to the short market, and if the lags are serious, the mere creation of large reserves may not lower the long-term rate. Keynes had this in mind when he wrote: “Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement that can be made in the technique of monetary management. . . . The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect re- actions from the price of short-term debts.” ‘ Keynes, it should be added, wanted the central bank to deal not only in debts of all maturities, but also “to deal in debts of varying degrees of risk,” i.e., high grade private securities and perhaps state and local issues.

That’s a quote from The General Theory, with Hansen’s gloss.

Fast-forward to 2014. Today we find Benjamin Friedman — one of the smartest and most interesting orthodox economists on these issues — arguing that the one great change in central bank practices in the wake of the Great Recession is intervention in a range of securities beyond the shortest-term government debt. As far as I can tell, he has no idea that this “profound” innovation in the practice of monetary policy was already proposed by Keynes in 1936. But then, as Friedman rightly notes, “Macroeconomics is a field in which theory lags behind experience and practice, not the other way around.”

Even more interesting, the importance of the rate structure as a tool of macroeconomic policy was recognized not only by the Federal Reserve, but by the Treasury in its management of debt issues. Hansen continues:

Monetary policy can operate on two planes: (1) controlling the credit base – the volume of reserve balances- and (2) changing the interest rate structure. The Federal Reserve has now backed away from the second. The Treasury emphasized in these hearings that this is its special bailiwick. It supports, so it asserts, the System’s lead, by issuing short- terms or long-terms, as the case may be, according to whether the Federal Reserve is trying to expand or contract credit … it appears that we now have (whether by accident or design) a division of monetary management between the two agencies- a sort of informal cartel arrangement. The Federal Reserve limits itself to control of the volume of credit by operating exclusively in the short end of the market. The Treasury shifts from short-term to long-term issues when monetary restraint is called for, and back to short-term issues when expansion is desired.

This is amazing. It’s not that Keynesians like Hansen  propose that Treasury should issue longer or shorter debt based on macroeconomic conditions. Rather, it is taken for granted that it does choose maturities this way. And this is the conservative side in the debate, opposed to the side that says the central bank should manage the term structure directly.

Many Slackwire readers will have recently encountered the idea that the maturities of new debt should be evaluated as a kind of monetary policy. It’s on offer as the latest evidence for the genius of Larry Summers. Proposing that Treasury should issue short or long term debt based on goals for the overall term structure of interest rates, and not just on minimizing federal borrowing costs, is the main point of Summers’ new Brookings paper, which has attracted its fair share of attention in the business press. No reader of that paper would guess that its big new idea was a commonplace of policy debates in the 1950s. [3]

Hansen goes on to raise some highly prescient concerns about the exaggerated claims being made for narrow monetary policy.

The Reserve authorities are far too eager to claim undue credit for the stability of prices which we have enjoyed since 1951. The position taken by the Board is not without danger, since Congress might well draw the conclusion that if monetary policy is indeed as powerful as indicated, nonmonetary measures [i.e. fiscal policy and price controls] are either unnecessary or may be drawn upon lightly.

This is indeed the conclusion that was drawn, more comprehensively than Hansen feared. The idea that setting an overnight interest rate is always sufficient to hold demand at the desired level has conquered the economics profession “as completely as the Holy Inquisition conquered Spain,” to coin a phrase. If you talk to a smart young macroeconomist today, you’ll find that the terms “aggregate demand was too low” and “the central bank set the interest rate too high” are used interchangeably. And if you ask, which interest rate?, they react the way a physicist might if you asked, the mass of which electron?

Faced with the argument that the inflation of the late 1940s, and price stability of the early 1950s, was due to bad and good interest rate policy respectively, Hansen offers an alternative view:

I am especially unhappy about the impli- cation that the price stability which we have enjoyed since February-March 1951 (and which everyone is justifiably happy about) could quite easily have been purchased for the entire postwar period (1945 to the present) had we only adopted the famous accord earlier …  The postwar cut in individual taxes and the removal of price, wage, and other controls in 1946 … did away once and for all with any really effective restraint on consumers. Under these circumstances the prevention of price inflation … [meant] restraint on investment. … Is it really credible that a drastic curtailment of investment would have been tolerated any more than the continuation of wartime taxation and controls? … In the final analysis, of course,  the then prevailing excess of demand was confronted with a limited supply of productive resources.

Inflation always comes down to this mismatch between “demand,” i.e. desired expenditure, and productive capacity.

Now we might say in response to such mismatches: Well, attempts to purchase more than we can produce will encourage increased capacity, and inflation is just a temporary transitional cost. Alternatively, we might seek to limit spending in various ways. In this second case, there is no difference of principle between an engineered rise in the interest rate, and direct controls on prices or spending. It is just a question of which particular categories of spending you want to hold down.

The point: Eighty years ago, Keynes suggested that what today is called quantitative easing should be a routine tool of monetary policy. Sixty years ago, Alvin Hansen believed that this insight had been accepted by all sides in macroeconomic debates, and that the importance of the term structure for macroeconomic activity guided the debt-issuance policies of Treasury as well as the market interventions of the Federal Reserve. Today, these seem like new discoveries. As the man says, the history of macroeconomics is mostly a great forgetting.

[1] I was surprised by how minimal the Wikipedia entry is. One of these days, I am going to start having students improve economics Wikipedia pages as a class assignment.

[2] What is “quantitative about this policy is that the Fed buys a a quantity of bonds, evidently in the hopes of forcing their price up, but does not announce an explicit target for the price. On the face of it, this is a strangely inefficient way to go about things. If the Fed announced a target for, say, 10-year Treasury bonds, it would have to buy far fewer of them — maybe none — since market expectations would do more of the work of moving the price. Why the Fed has hobbled itself in this way is a topic for another post.

[3] I am not the world’s biggest Larry Summers fan, to say the least. But I worry I’m giving him too hard a time in this case. Even if the argument of the paper is less original than its made out to be, it’s still correct, it’s still important, and it’s still missing from today’s policy debates. He and his coauthors have made a real contribution here. I also appreciate the Hansenian spirit in which Summers derides his opponents as “central bank independence freaks.”